Very short-lived enthusiasm

Market analysis
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12/7/2018

Chain reactions. Markets had rebounded when China and the US agreed on a ceasefire at the G20 but hopes that relations would take a turn for the better were quickly dashed.

Risk aversion remained high due to doubts that the agreement would be implemented. However, China‘s willingness to increase imports and signs of upbeat economic trends were reassuring, albeit insufficient. Investor concerns that the trade war might persist took US Treasury yields lower while expectations that falling oil prices would cause inflation to slow also weighed on sentiment.

The arrest in Canada of Wanzhou Meng, CFO of Huawei and daughter of the founder, at the request of the US also caused a chill in relations between Donald Trump and Xi Jinping. Huawei has 12% of the global market and is second to Samsung in volume terms. The group is also the fifth largest buyer of semiconductors in the world (3.5% of demand).

Doubts on the sustainability of the US growth cycle increased when the 10/2-year US yield curve flattened and after the inversion, albeit microscopic, of 5 and 3-year Treasury yields. Historically, an inverted yield curve is an advanced indicator of recession but the period before this actually happens can vary. For example, the curve had been negative for more than 2 years before the 2008 crisis. Nevertheless, yield curve flattening could be attenuated by a number of economic indicators that suggest the US economy is still thriving and that the Fed is on the right track.

The Fed’s Beige Book says the economy is growing even if there are signs of a brake on activity in some districts. Company heads are however still worried about customs duties and the residential housing market has reached a plateau. The labour market is still tight and wages are being pushed higher.

In all, a week of chain reactions and a new risk-off episode.

European equities

It was a very complicated week on markets. First, the UK situation became less clear after the government was found in contempt of parliament for failing to reveal in full the legal opinion on the recent Brexit deal. The general attorney’s advice stressed the extremely restrictive nature of the Northern Ireland backstop which might force the UK to stay indefinitely in a customs union, thus preventing it from concluding trade agreements with countries like China, India and the US.

Elsewhere, Manuel Campos Sanchez Bordona at the European Court of Justice issued a non-binding opinion that the UK could unilaterally cancel its decision to leave the European Union without needing the approval of other country members. And an amendment passed by the House of Commons means that Parliament will have the last say on the Brexit deal if Theresa May’s agreement fails to win approval at the December 11 vote. As there is a parliamentary majority in favour of remainers, the chances of no deal are now less probable. But the risk of political chaos cannot be ruled out.

In France, which is still mired in a growing wave of protests, the government cancelled the fuel tax hikes which were meant to come into force on January 1st. Electricity and gas prices were also frozen until May 2019. The tax shortfalls should be limited to around €4bn or 0.2% of GDP but the measures could push the deficit above the EU’s 3% limit.

Meanwhile, Wanzhou Meng, CFO of Huawei and the daughter of the group's founder, was arrested in Canada following a request from the US which wants to extradite her on charges of violating Iranian sanctions. The news trigged another black Thursday on financial markets and clouded last weekend’s trade truce between Washington and Beijing at the G20 summit.

To make matters worse, there was little joy from companies this week. Altran slumped on news that Altran North America’s chairman Frank Kern had retired. He is the former CEO of Aricent, acquired this year by Altran, which is suspected of accounting irregularities. And yet, Laila Worrell, who was appointed CEO of Altran North American last July, is doing an excellent job to help margins recover. Frank Kern was meant to stay until the successful integration of Aricent which is now on the right track.

In other news, Fresenius had shaken investors in October by turning more cautious and guiding on earnings growth for 2018 coming in at the low end of its 6-9% bracket. Management has now moved to avert fresh disappointment in 2019 by reducing over-ambitious medium-term objectives.

However M&A deals are still going ahead despite political and market turmoil: Unilever is paying €3.3bn for GSK’s health food activities and India’s Boost Brand while Tesaro (biotech) is to be bought by Boost Brand for £4bn so as to create an oncology franchise.

US equities

In a short and very tricky week, the S&P lost 2.3% and the Nasdaq ended the period 1.4% lower. The S&P’s year-to-date returns have now shrunk to 0.8%. US-China relations were once again the main market driver.

However this week’s macro data were generally better than expected with manufacturing ISM coming in at 59.3 or higher than expectations of 57.5. The new orders subsection rose from 57.4 last month to 62.1. Non-manufacturing ISM also beat expectations by rising from 59 to 60.7. However, durable goods orders fell 4%.

Markets had risen on hopes for a US-China agreement which would have abolished duties on US cars but then Beijing contradicted Donald Trump’s comments and indices fell back heavily. The down trend was accentuated by news that the finance director of Huawei, and the founder's daughter, had been arrested in Canada on a US request on suspicions of violating the US embargo on trading with Iran. However, the real issue appears to be worries that Huawei has been involved in industrial espionage.

This week’s other big development was the yield inversion on US 2 and 5-year Treasuries. The 2-year yield (2.76%) moved above the 2.74% yield on 5-year Treasuries while the curve at the long end continued to flatten. The spread between yields on 2 and 10-year maturities fell to only 12bp. This is often seen as an advanced indicator of recession and it only added to market pessimism.

Meanwhile, oil prices continued lower following OPEC’s failure to reach an agreement on cutting production during the first day of its meeting. US oil exports this week hit a new record of 3.2 million b/d, making the US a net exporter for the first time in decades.

Unsurprisingly, defensives proved the most resilient over the week (utilities +2.3%, healthcare -0.8%) while financials tumbled 5.5% and energy lost 2.3%.

Japanese equities

Mounting concerns over a possible global downturn sent Japanese equities lower again. US-China trade tensions revived after the CFO of China’s tech giant Huawei was arrested in Canada. A broad range of industries in the Electronic Appliances and Machinery sectors as well as China-related names were dragged down.

In addition, financials such as Securities & Commodities Futures, banks and insurance had trouble rebounding due to falling Japanese bond rates and the reverse yield curve in the US.

In contrast, domestic plays like Electric Power & Gas, Real Estate and Mining were relatively firm.

Elsewhere, Takeda (-3.55%) saw its strategic acquisition of Shire to become a mega pharma group approved at an extraordinary shareholders’ meeting. SoftBank Group fell 4.26% ahead of its telecommunication subsidiary’s IPO partly because of a communication disruption incident.

The TOPIX lost 3.41% this week, sending its forward P/E down to 13.59 and 12.09 for the Nikkei 225.

Emerging markets

The US and China agreed on a trade war ceasefire after the Trump-Xi G20 dinner meeting. The suspension of further tariff hikes for 90 days should give both sides some time to negotiate further details of trickier subjects like protecting intellectual property. China showed strong willingness to strike a deal by announcing new law enforcement measures only 2 days after the meeting: repeated IP infringers will be banned from issuing bonds, excluded from government procurement and restricted from foreign trade. The Supreme Court is also setting up a specialised IP appellate court to review local rulings. However, the risk of an escalation in tension remains high after the arrest of Huawei’s CFO Canada after a US request.

China’s healthcare sector was under pressure this week as the government released centralised procurement results on 31 selected generic drugs in 11 pilot cities with an average price cut of 45%. 13 products had price cuts of more than 50%, or much more than market expectations. Smartphone value chain names in Asia-Pacific got hit again as Largan, a major camera module supplier for Apple, reported a 23% MoM decline in November sales (-29%YoY), or worse than market expectations of 10-15%. The management guided on a sequential decline into December due to weaker demand.

In Indonesia, BCA is to allocate 40% of capital expenditure to digital banking next year.

India’s third quarter GDP growth fell sharply from 8.2% in the second quarter to 7.1% YoY. The consensus had pencilled in +7.5%. The fiscal deficit widened for the fourth consecutive month by weak receipts. The financial conditions will tend to be tight as the recent shadow banking liquidity crisis is likely to have an adverse impact on consumer discretionary demand, commercial real estate and small and medium companies.

In Mexico, PMI and consumer and business confidence waned. Same store sales at Walmex rose 5.9% in November, above inflation, but in line with the consensus.

In Brazil, October industrial production was lower than expected due to Argentina, which suffered a broad contraction in industrial and construction activity.

In Russia, inflation accelerated in November to 3.8% YoY from 3.5% in October. Food inflation surged to 3.5% from 2.7% a month ago. The central bank’s rate decision will be on 14 December as headline inflation may trend higher given VAT hikes planned in the first half of 2019.

Commodities

Splits appeared between OPEC and its allies, Russia in particular. OPEC had as of December 6 failed to reach an agreement on production cuts and especially each member’s contribution to the effort. A proposal for a 1 million b/d cut was on the table but Saudi Arabia was said to be keen on a more significant reduction. Russia, which is less dependent on oil revenues than Persian Gulf states, is only willing to cut by 150,000 b/d while Riyadh wants it to double that amount. Since 2016, supply and demand adjustments have essentially depended on the Saudi Arabian and Russian tandem with Moscow’s influence steadily gaining ground. When the news of no agreement was announced last Thursday, Brent crude lost 2.3% and WTI 2.6% but the reaction was still relatively muted. At the time of writing, market players were still assuming that the meeting would reach an agreement to cut by 1 million b/d so as to help prices stabilise at $60 for Brent crude and $50 for WTI. No agreement at all would necessarily entail a strong correction of at least $5. On the other hand, an agreement to reduce by 1.5 million b/d would help Brent move back towards $70.

Meanwhile, the US has for the first time become a net exporter of oil (including oil products). This is not only due to higher shale oil output but also the $10 price differential with Brent which has helped exports. The huge gap between Canada’s WCS and WTI which had reached $50 (WCS was trading at only $15 in November) has led the oil sands province of Alberta to cut production by close to 9% or 325,000 b/d, the same amount that Russia is being asked to forego. The news helped WCS to claw back close to $15 but there will be no impact before January 1st and then chiefly on US oil inventories.

Corporate debt

Credit

Credit markets started the week in optimistic mood following the US-China trade ceasefire. But the rally quickly fizzled out over the finer details of the agreement and its actual implementation was threatened when the finance director of Chinese tech giant Huawei was arrested in Canada. Brexit also weighed on spreads after the House of Commons voted down a government motion even before the beginning of the debate on Theresa May’s recent agreement. The Xover widened by 20bp between Monday and Thursday and the Main by around 6bp.

In regulatory news, the European Council and Parliament reached an agreement on the CRR/CRD/BRRD banking package. However, not all the texts were approved.

CMC Di Ravenna’s bonds suffered further pressure this week after the group’s request for creditor protection but “with reservations” under Italy's bankruptcy law. S&P subsequently cut the group's debt rating to D. Thomas Cook’s bonds were also under attack after last week's profit warning. Moody's downgraded the group from B1 to B2 with a negative outlook citing deteriorating credit ratios and reduced liquidity. But the bonds rallied slightly at the end of the week on indications that the group did not need to raise capital.

Moody’s also cut Atalian’s debt from B2 to B3 and revised its outlook to negative. The bonds immediately slumped by 4 points.

On a brighter note, Swissport (B3/B-) reported a 6.3% rise in sales with EBITDA 24% higher. This was in part due to Aerocare, integrated since March 2018, and by growth in freight traffic.

Elsewhere, Altice France (B1/B) is selling 49.9% of its optical fibre network, SFR FTTH, to an investor group for €1.8bn. The deal should complete in the first half of 2019 and will help reduce leverage by 0.3 times to around the group’s overall level. According to press reports, Casino has completed its €1.5bn asset disposal plan and is now aiming to raise it to €2bn so as to increase the pace of deleveraging.

Convertibles

It might have been a quiet week after the G20 summit and with Wall St closed on Wednesday. However, the arrest of Huawei’s CFO in Canada reignited trade war volatility and sentiment was dragged down by the apparent failure to reach agreement at the OPEC meeting on cutting production quotas and severe flattening in the US 2- and 10-year yield curves, normally a harbinger of recession. Meanwhile, Europe continued to worry investors with more social strife in France, internal CDU elections in Germany and the ongoing Brexit and Italian budget sagas. Markets sold off mid-week amid soaring volatility.

Inevitably, companies reporting disappointing figures endured big falls. SGL Carbon plunged 20% after announcing higher investment while revising down guidance for 2019 to reflect uncertainty over economic trends. However, the short-term outlook improved. Supernus Pharmaceuticals tumbled more than 15%. The company said Phase 3 trials for its new epilepsy drug were promising even if less effective than expected. Expectations for future earnings are still upbeat and no analysts have sell recommendations on the stock.

In new issues, Spain’s Almirall (dermatology) raised €250m at 0.25% and a 27.5% premium to fund its acquisition of Allergan’s Medical Dermatology.